Previously, with the further support of market data, economic practitioners generally expected that the Fed would end this round of interest rate hike cycle in 2024 and start a new round of interest rate cut cycle, and then in the last interest rate decision meeting of the year, Fed Chairman Powell's attitude made the possibility of a rate cut next year greatly increased.
As with the lagging variable that central banks often watch, the timing of a rate cut may be just right, as a plethora of indicators point to a resurgence of inflation later next year, and it is clear that the market's expectations for a rate cut now seem overdone, but any repricing is likely to wait until there is a light in the light of day, and if it does, perhaps the move will be dramatic.
Now fullIt is difficult to find a perfect analogy between the global economy, especially the developed economies of the West led by the United States, when compared with history.But economic history has a rhythm, because there is one thing that is timeless: human nature.
The '70s of the 20th century differed from today in several ways, but the immutability of human behavior made it possible for a similar inflationary pattern to reappear.
In those days, price growth was a thingA play in three actsThe first act is when inflation hits a new high after the Fed's over-easing;The second act isIn the opinion of policymakersInflation has been defeated in the case of interest rate cuts, but the time is not yet ripe;The third act is when growth accelerates again, and growth unexpectedly begins to climb.
People always tend to extrapolate linearly, thus missing the turning point.
The problem with inflation is that it is one of the most lagging of all economic variables, usually reaching a trough when the economy expands and peaking in a recession. We are likely to be heading for a trough, with a growing number of leading indicators suggesting that inflation will start to pick up as early as the second half of next year.The focus is usually on the headline consumption index, which has moved 85% from its recent highs to its 2% target. But a more comprehensive look at inflation reveals that the decline in inflation has been much smaller, with the median of a broad range of growth measures remaining very high compared to pre-pandemic standards.
The sharp decline in inflation vindicates the increasingly optimistic outlook for the Fed and other central banks, but the tipping point seems to be on the line.
We begin to feel that we are in the second act, which is premature"Clearance", and the third act is about to begin. Note that we have in fact eased interest rates substantially. Goldman Sachs' Financial Conditions Index is designed to translate into effective changes in the Federal Reserve's interest rates.If we add the decline in the policy rate due to loose financial conditions with the market's expectation of a rate cut next year, then the Fed's real interest rate has fallen sharply.
So inflation potential was already rising before the Fed cut rates, which is why the Fed's recent pivot was a huge gamble.
We can clearly see this pipeline inflation, and the chart below needs no too much comment, making it clear from multiple angles that deflation will soon end and growth will start picking up later next year. The first is stress. After the global lockdown was clearly eased and is now climbing rapidly, the Red Sea events that are now taking place remind us how fragile chains can be in a world of heightened geopolitical risks.
The second is wages. Wage growth has been declining, but remains positive in real terms. Importantly, leading indicators suggest that wage growth will pick up starting next year. The pay plan portion of the NFIB survey has started to pick up, and the Fed's regional wage survey has also picked up strongly, leading average hourly earnings by about six months.
The third is inflation expectations. Inflation expectations fell sharply when central banks raised interest rates, and now they are starting to pick up again.
Then there's the profit and profit margin.
Profits are now the biggest driver for businesses, and labor costs were the biggest driver in the decades leading up to the pandemic. Profit margins have declined in the wake of the pandemic, but are now stagnant at higher levels. Large fiscal deficits are likely to push profit margins higher again next year.
The fifth key factor is the emerging economies represented by China.
It is one of the main drivers of deflation in the US and globally (more directly than the direct impact of central bank rate hikes), and they are using their borrowing power to ramp up stimulus, while banks are pumping more and more liquidity into the system, such as (chart below) China's economic turnaround is likely to occur in 2024, which will create a significant inflationary tail-end factor for the world.
In addition, global goods** are also starting to recover. These** are about six months ahead of the U.S. CPI.
Finally, there is the leading indicator of inflation (below), which is 6 months ahead of the US CPI, and now the latest data reality seems to have stopped falling and is about to start picking up.
Much of the decline in U.S. inflation is driven by cyclical factors, such as energy.
Structural inflation, defined as a sub-component of the consumer price index that is consistently above the long-term average, has also declined but remains elevated (see chart below).
Herein lies the problem: structural inflation appears to have started to pick up, and the risk of a cyclical recovery is rising (oil** has been climbing), reinforcing the upward momentum of structural inflation.
The inevitable consequence of this is that headline inflation begins to accelerate again.It may be unfortunate for central banks to miss one or two signs of rising inflation, but it would be careless to miss at least eight, and with the downward trend in inflation for CPI fixed swaps continuing into 2024, markets will likely have to recalibrate the inflation outlook sometime next year.
However, the Fed's frenzied ** shift could lead it to cut interest rates as it always did when the third inflation is about to begin.